Written by The Dividend Sensei (https://dividendsensei.com/)
The Federal Reserve is the most powerful central bank on earth, and its decisions about interest rates have wide ranging ramifications for global capital markets, the economy, and ultimately the stock market. So let’s take a look at the three most important things investors need to know about the last Fed meeting, the future of interest rates, and most importantly how it will effect your portfolio.
Fed’s Forecast For Economy
The most important thing to know about the Federal Reserve’s Open Market Committee or FOMC (which sets US monetary policy), is its dual mandate. That would be to minimize unemployment (strong economy) while maintaining stable prices (core inflation of 2.0% over the long-term). The Fed uses various models in determining where to set its Federal Reserve Funds Rate or FFR. That’s the overnight lending rates that banks charge each other for overnight loans. Banks index their prime rate, (from which short-term and variable lending rates are set) to the FFR. Thus when the FFR rises, so do consumer borrowing costs. This is why the Fed uses the FFR to try to stabilize the economy, by either slowing or accelerating growth by indirectly affecting consumer spending which makes up about 65% to 70% of US GDP.
Under current Fed Chairman Jerome Powell, the Fed has stated it’s being driven by the data, specifically the current and expected growth rate in GDP and inflation. Thus to understand where the FFR is likely to go we need to know where the Fed thinks where the economy, inflation, and unemployment are headed.
The Fed’s latest estimate of US GDP growth showed an increase in 2018 and 2019’s expected growth rates, from 2.8% and 2.4%, respectively, to 3.1% and 2.5%, respectively. 3.1% economic growth (which we’re on track to hit this year from the latest data), would be the fastest full year growth since 2005.
However, the Fed expects growth to slow in 2019 and 2020 as the stimulus effects of tax cuts and $300 billion in greater government spending wear off. By 2021 the FOMC expects growth to be back to its long-term steady state level of 1.8%. The Fed expects this stronger short-term growth to lower unemployment to 3.6% (from 3.9% today) by the end of the year, and bottom at 3.5% in 2019 where it will remain in 2020. Because the Fed estimates the natural rate of unemployment (the lowest level that doesn’t increase inflation via stronger wage growth) to be 4.5% the Fed thinks that its key inflation metric, Core PCE, will hit 2.1% in 2019 and remain there through 2021. Today core PCE is at 2.0%, precisely the Fed’s target long-term rate, and has remained stable at this level for four straight months.
So what does this somewhat disappointing long-term economic forecast mean for interest rates?
Fed’s Forecast For Short-Term Interest Rates
Each Fed meeting brings with it an updated “dot plot” or graphical representation of where each FOMC member (there are 12 who vote on rate hikes) thinks the FFR will wind up by the end of each year.
The June meeting saw the Fed deliver its 3rd rate hike this year (and 8th this tightening cycle) as planned. The FFR is now between 2 and 2.25%. The Dot plot became slightly more hawkish and shows one more hike this year (likely December), three next year (likely March, June and December), and two in 2020. That’s a total of 6 more rate hikes, which would mean 14 hikes this tightening cycle and an FFR that peaks at 3.5% to 3.75%. Then there’s one rate cut expected in 2021 and another one in 2022. Basically the Fed is indicating that it thinks that low unemployment might put the economy at risk of rising wages that might keep inflation slightly higher than it likes, even with growth slowing back to a sub 2% rate. Effectively the Fed’s current plan is to indirectly raise consumer lending rates by 1.5%, in order to keep the economy from overheating by pushing interest rates far above its estimated neutral rate of 2.9%. The neutral rate is the FFR at which the FOMC’s consensus is that the economy will neither be slowed, or accelerated (thus neutral).
So does this mean investors (and borrowers) need to worry about rising rates? Not necessarily. That’s because the dot plot is merely the equivalent of corporate earnings guidance. It’s a plan and forecast but can always change over time. In other words, if the data shows inflation is lower than expected (like core PCE stays stuck at 2.0%) then the Fed isn’t likely to go through with its planned 6 more rate hikes. The bond futures market, where large financial institutions bet billions via interest rate futures (to hedge their rate risk), shows the world’s capital markets think the Fed will have to stop hiking after just two, or maybe three 25 basis point increases.
That’s great news for anyone worried about the Fed inverting the yield curve, by driving short-term rates above long-term treasury yields. Historically this has been followed by a recession 90% of the time (within 6 to 24 months). What about the common concern that rising interest rates will hurt stocks? Well you can breathe easy. That’s because the most important thing to know about interest rates is the FFR is not what stocks primarily care about.
Stock Market Mostly Cares About Long-Term Interest Rates
There’s a common misconception that Fed rate hikes hurt stocks directly. That flawed belief stems from the notion that rising interest rates will cause investors to pull money from stocks to put them into higher-yielding and risk free bonds. While that’s a plausible sounding argument in fact what the stock market cares most about is long-term interest rates like the 10 year treasury yield.
As you can see, while short-term treasury yields are indeed highly correlated with the FFR, 10 year yields are not. That’s because short-term treasury yields must compete with cash equivalents like savings accounts and money market accounts. The rates on these are indirectly linked to the FFR (thought they rise slower than the FFR). However, long-term bonds are set by the largest and most liquid bond market on earth (about $15 trillion in size) driven by institutional cash flows from pension funds, insurance companies, central banks, mutual fund companies, and sovereign wealth funds. These mostly care about the long-term inflation rate, which eats away at bond total returns (since interest payments on bonds are fixed). Currently the 10 and 30 year Treasury yields are pricing in 2.15% long-term core inflation. That means that should inflation fail to rise to that level, 10 and 30 year yields are likely to not only stay stable, but would probably pull back a bit.
According to JPMorgan Asset Management between 1963 and March 2018, stocks were not hurt by high 10 year yields as long as they were at 5% or below. In order for 10 year yields to rise to 5% core inflation would have to rise about 3% to 5%. That’s nowhere near what either the FOMC or bond markets think is possible, given the slowing growth rates the US is likely facing due to 10,000 baby boomers retiring each day (and thus shrinking the labor market).
What implications does that have for stocks? Well for one think it means that long-term rates are likely to remain near current levels for much of 2018, when economic growth and rising inflation risk will be the highest. But as we’ve seen over the past few months (Q3 was the strongest for the market since Q4 2013), stocks are currently not being hurt by 3% 10 year yields. As long as corporate earnings continue to grow at a brisk pace (20% in 2018 and 10% projected 2019) the bull market is very likely to continue.
What about high-yield “bond alternatives” like utilities, REITs and dividend stocks in general? Well while these can be sensitive to the 10 year yield in the short-term (mostly impacted by the speed that rates rise), over the long-term there is no correlation between total returns and long-term interest rates. That’s because all stocks, REITs included, ultimately trade off fundamentals, specifically cash flow and dividends. If the economy is strong enough to justify rising long-term rates, then these companies pass on rising costs (higher inflation) in the form of rent or price increases that allow their cash flow and payouts to keep growing. That ultimately drives up share prices.
This holds true as long as 10 year yields are 5% or below. And since rates are very unlikely to go above those levels, investors, and dividend investors in particular, have little reason to fear the Fed’s planned (but unlikely) six additional rate hikes.
Bottom Line: The Fed’s Future Rate Hikes Are Not Set In Stone And Are No Reason To Adjust Your Long-Term Portfolio Strategy
The reason the Fed produces its dot plots and does its quarterly conference calls is to give capital markets clear guidance of where it thinks the economy, inflation, and the FFR are going. But the Fed isn’t clairvoyant. So remember that dot plots and economic forecasts are merely educated guesstimates that are a rough guide, never a promise or threat. The Fed’s interest rate decisions ultimately are data driven, which is why you should avoid making short-term investing decisions based on Fed meetings, or what the media reads into them.
In the end long-term interest rates are what the market, including dividend stocks, care most about. And even if the 10 year yield were to rise a bit, ultimately that won’t hurt high-yield stocks like REITs, utilities, or blue chip income investments. Which means the best thing you can do right now is stick to your long-term investment plan, and not lose sleep over the Fed’s planned six additional rate hikes; which are unlikely to even happen.